Justin Goldstein, AIF®, Director with Bronfman E.L. Rothschild
Shane Workman, Wealth Advisor with Bronfman E.L. Rothschild
As a 401(k) plan sponsor, you have already taken the important step to offer a significant benefit that can help your employees save for their retirement. However, many companies that offer an attractive retirement benefit still find a portion of their employees do not participate in the plan. According to the U.S. Department of Labor (DOL), roughly 30 percent of eligible workers do not participate in their employer’s 401(k) plan.1 Further, even among those who do participate, many are not saving enough. While financial advisors suggest saving 10 to 15 percent per year to achieve a comfortable retirement, the average plan participant does not achieve that level of savings.2
To engage more participants, some plan sponsors are adding automatic features to their 401(k) plans to increase savings and help employees save effectively for retirement. Forty-one percent of large companies offer automatic enrollment and 43 percent of large companies offer automatic increases.3 When asked, participants also say they want these features. According to Plan Sponsor magazine, 71 percent of employees would like to be auto-enrolled into their plan, and 67 percent would like the plan to include auto-escalation.4
The Pension Protection Act of 2006 (PPA) helped increase acceptance of automatic enrollment by plan sponsors by offering guidance and protection to plan fiduciaries about offering default options to employees who do not make their own selections. The PPA also overrode state laws requiring employee affirmation prior to withholding deductions from payroll.
Here we will look more closely at features such as automatic enrollment and automatic increases or escalation, and hopefully help you determine whether they are right for your plan.
Why Add Automatic Features to your 401k plan?
Information is widespread about the need for individuals to save for retirement, and many employers offer very attractive incentives for their employees to save, including generous matches. Still, a significant number of employees fail to get the ball rolling with their 401(k) plan. Some may be using the money to pay off debts, buy a home, or even cover basic living expenses. Still others may think retirement is a long way away. But with the cost of retirement increasing and workers living longer, establishing saving habits early can make a huge difference. And workplace retirement plans are a very effective way to save.
Behavioral economists have done a number of studies pointing to the reasons why participants fail to do things that are obviously in their best interest. Understanding that failure to enroll in an available 401(k) plan is one of the most common examples of these behaviors, those same economists have recommended automatic features as a way to counter illogical behavior.5
Similarly, inertia and myopia often keep participants from making changes or increasing their savings over time to meet their retirement goals. Studies have shown that features that automatically step up contributions each year can help participants steadily increase their savings up to the legal limits.
Numerous studies have shown how automatic plans improve participation and savings levels:
- The Department of Labor noted that automatic enrollment could reduce by half (from 30 percent to 15 percent) the number of participants who do not participate in a plan and helps increase participation among both rank-and-file employees and owners/managers.1
- According to the Defined Contribution Institutional Investors Association (DCIIA), among plans that offer automatic escalation, almost one-third of respondents reported actual savings rates greater than 10 percent, while for plans without automatic escalation, only one-fifth of participants had savings rates over 10 percent.6
- The employers of automatically enrolled workers are more likely to make contributions and to contribute, on average, higher amounts and a higher percentage of their employees’ earnings.7
In addition to improving participation and increasing the amount employees defer to their retirement plans, adding automatic features can have significant tax advantages. In addition to the well-known benefit for employees of deferring taxes on their contributions and earnings until distribution, employers can deduct their contributions. In addition, automatic enrollment increases participation in the plan improving the chance that a plan will pass the Internal Revenue Code’s nondiscrimination testing.
Establishing an Automatic Enrollment Feature
Modifying your existing plan to add automatic enrollment involves a number of steps.
Step One: Update plan documents
The Department of Labor defines several types of automatic enrollment plans:
- A basic automatic enrollment 401(k) plan must state that employees will be enrolled in the plan unless they elect otherwise and must specify the percentage of an employee’s wages that will be automatically deducted from each paycheck for contribution to the plan. The document must also explain that employees have the right to elect not to have salary deferrals withheld or to elect a different percentage to be withheld.
- An eligible automatic contribution arrangement (EACA) is similar to the basic automatic enrollment plan but has specific notice requirements. An EACA can allow automatically enrolled participants to withdraw their contributions within 30 to 90 days of the first contribution.
- A qualified automatic contribution arrangement (QACA) is a type of automatic enrollment 401(k) plan that is designed to pass certain kinds of annual required testing. The plan must include certain features, such as a fixed schedule of automatic employee contributions, employer contributions, a special vesting schedule, and specific notice requirements.
Once you have identified the type of automatic enrollment plan, work with your plan administrator to modify your 401(k) plan documents to include the appropriate description.
Step Two: Determine the Default Deferral Amount
When an automatic enrollment plan is in place, the employer must identify a specific percentage that will be deducted from each participant’s salary unless the participant opts out or chooses a different percentage. This deferral amount plus any employer match cannot be more than the legal contribution limits which currently are:
- 100 percent of the employee’s compensation, up to a total contribution that cannot exceed $54,000
- The amount an employee can contribute both as pre-tax salary deferrals or after-tax Roth Contributions (if permitted) is limited to $18,000 for 2017
- Those over 50 are allowed catch-up contributions of an additional $6,000
It can be challenging for employers to select a deferral amount that isn’t so high that employees opt out of the plan. While the average default deferral rate has increased over the years from around 3 percent to over 6 percent3, many employers select 3 percent believing this is a rate that would keep automatically enrolled participants from opting out of the plan.7
In addition, expanding participation by adding automatic enrollment can have an impact on the level of the match: matches on plans with automatic enrollment tend to be lower. A study by the Urban Institute and the Boston University Center for Retirement Research found that when employees are automatically enrolled in 401(k) plans, employers set lower limits on the contribution level they match, an average of 3.2 percent, compared to 3.5 percent in plans without auto enrollment.3
Step Three: Determine who will participate and who will be excluded from automatic features
Most employers automatically enroll all employees with a few exceptions:
- Those who are not yet age 21
- Those who do not meet the minimum years of service (usually 1 year) to participate in the plan
- Those who are a member of a union and are covered by a collective bargaining agreement.
Step Four: Choosing a default investment option.
For many years, plan sponsors were concerned about exposing themselves to legal liability by their selection of a default option that included market risk. On the flip side, there was concern that selecting a conservative or guaranteed opportunity would not provide a high enough return opportunity to help employees reach their long-term goals. However, with the previously mentioned passage of the PPA, the Employee Retirement Income Security Act (ERISA) was amended to create a safe harbor for plan sponsors to select certain default investments such as a target date or balanced mutual fund that can provide greater long-term opportunity for participants. As fiduciaries, plan sponsors must still follow appropriate steps to assure that they have been prudent in selecting these options and continue to monitor them.
To qualify for safe harbors, a plan sponsor offering default options must meet these conditions:
- Select from certain types of qualified default investment alternatives (QDIAs) that are diversified to minimize the risk of large losses and provide long term growth including:
- A lifecycle or target date fund that offers an investment mix or asset allocation based on the employee’s age or projected retirement date
- A balanced fund
- A service that allocates contributions among plan options to provide an asset mix that takes into account the participant’s age and projected retirement date
- A capital preservation, money market or stable value fund is allowed but only for the first 120 days after the participant’s first contribution for those plans, such as EACAs (see above) that permit employees to withdraw their automatic contributions between 30 and 90 days after the first automatic contribution. After 120 days, if no action is taken, plan sponsors must redirect the investment to one of the QDIAs noted above.
- Provide notice to participants about the automatic enrollment process.
- Place a participant in the default option only if the participant provides no investment direction.
- Share information with participants such as a prospectus describing the investment election.
- Provide periodic opportunities to participants to direct their investments from the default option into other options offered by the plan.
- Default investments cannot include employer securities (such as employer stock).
Step Five: Communicate with employees about the automatic enrollment
An automatic enrollment notice must be shared with participants and include:
- The default deferral percentage
- Information about the participants’ right to change that percentage or opt out of the plan
- The default investment election
This notice should arrive at least 30 days but not more than 90 days before they become eligible to participate. Under certain conditions, notice can be provided so an employee can begin participating on the first day of work. An annual notice should be provided to all eligible employees each subsequent plan year.
Automatic escalation, or automatic increases, allow a plan sponsor to increase participant deferrals annually by a set percentage, usually 1 percent, until they reach the maximum contribution limit.
A study by Aon suggests that employees need to save at least 15 percent per year to have enough for retirement.7 For employees who start later or are enrolled automatically at a much lower deferral rate, increasing the deferral amount can be all the more important.
An auto escalation plan that increases the amount set aside each year by 1 percent can help. Starting with an initial deferral rate of 3 percent, it would take seven years to get to double digits. Starting at a higher deferral rate of 6 percent and increasing the escalation to 2 percent per year will get a participant to a double digit saving rate in three years.8
Another tip to make adding auto-escalation more successful is to time the annual increase with annual raises if the company does those at a fixed time every year. This way, employees will never see their paycheck go down, thus avoiding loss aversion. This ensures that the ‘current’ version of the employee and the ‘future’ version of the employee are both taken care of.
Concerns that Prevent Employers from Adding Automatic Features
While automatic enrollment and automatic escalation are gaining popularity, there are still some employers that have yet to add these features. A study from the Society of Human Resource Management offered the top reasons employers choose to not offer automatic escalation:
- Too paternalistic toward employees
- Employees would complain
- Too costly for the company from a matching perspective9
The paternalistic argument is the most frequently heard. However, if a plan sponsor makes a conscious decision to NOT help participants get to retirement, aren’t they still making a decision? When reexamining this way, it may make the most sense to err on the side of an employee’s best interest. And when it comes to concerns about complaints, an emphasis on communication is key. Ensure not only that employees are informed of the feature in writing and verbally, but that employees are educated of the benefits they receive through auto-enrollment and escalation.
Once enacted, employers can find automatic enrollment and auto escalation features effective keys to improving both participation and asset balances. Education is the key to improving awareness for both participants and plan sponsors.
Bronfman E.L. Rothschild is a registered investment adviser. Securities, when offered, are offered through an affiliate, Bronfman E.L. Rothschild Capital, LLC (dba BELR Capital, LLC), Member FINRA/SIPC. © 2017 Bronfman E.L. Rothschild, LP